Among several forms of investment companies, one form is open-ended, generally referred to as a mutual fund. These types of funds issue shares to investors in usually unlimited amounts and redeem shares from investors who need liquidity. By law, mutual funds buy and sell shares at net asset value (“NAV”). NAV means total assets owned by the funds less any liabilities divided by the number of shares outstanding. There are many thousands of such funds outstanding.
Since NAV is burdensome to determine at any given time, most funds calculate the NAV at the end of the day. Virtually 99% of funds do this and investors purchase and sell their fund's shares at NAV calculated at the end of the day. The investor typically does not know the price at which shares are purchased and sold until the end of the day, after the trade is executed. Mutual funds are the most common form of investment company.
Derivatives of which a total return swap is one type, are not uncommon and are gradually being used by more investment managers to hedge the risk of an asset in a portfolio or to increase returns from a portfolio through leverage, providing they have been duly authorized. Funds and investment companies use derivatives for those two purposes to complement their overall investment strategies. On the other hand, derivatives have been the cause of some major losses in past years, which results have been well-publicized. In these cases, derivatives were used to take on greater risk for greater returns; they were very complex and not readily understandable. While senior officials at the Federal Reserve System have praised derivatives for innovation in financial markets and implicitly encouraged use, many still fear derivatives. As a result, they are avoided by most investors, especially low risk investors such as money market funds which emphasize safety and liquidity.
Total return swaps provide a means by which investors can gain an exposure to particular assets, called reference assets. The exposure is the same as if the assets were owned directly, including, potential gains in value of that security and any distributions thereon, and at the same time, losses due to any declines in value of the reference asset. In return for receiving the exposure to that asset, the investor typically pays a finance or swap rate on the market value of the reference asset. Typically, that finance rate is a LIBOR-based rate and generally is a means to compensate the payer of the return for the implicit funding cost that it incurs for hedging the swap inclusive of capital allocation costs and for the counterparty credit risk.
The return from having a cash position in the underlying asset for the swap is the same as the return received by the counterparties to the swap. The difference is the LIBOR-based finance rate on the market value of the underlying assets, which is paid to the payer of the return. As an example, if Party A wants the exposure to asset XYZ, it will acquire such through a swap contract with Party B. That contract will provide that Party B pays to Party A the return on XYZ and Party A will pay to Party B a LIBOR based finance rate on the market value of XYZ. The return on XYZ will include the distributions received on XYZ and any increase in the market value of XYZ, meaning the Party B will pay capital gains in XYZ to Party A. But Party B will receive from Party A any decline in value of the XYZ security. The payment exchange will be made daily or another period agreeable by the parties. The amount against which the finance rate is applied is called the notional principal amount of the contract.
As a result of the total return swap and as long as it owns XYZ, Party B is fully hedged for the market value exposure of XYZ. This is the manner in which investors use total return swaps. Party A gains exposure to XYZ by putting up little to no cash except that required by Party B for collateral margins. The advantage to Party A is a leveraged off balance sheet investment. That has the impact of increasing returns to Party A, based upon its total assets. Party B has the advantage of maintaining a perfectly hedged position, has only counterparty credit risk for which it can protect itself in a traditional manner and earns a spread versus its funding cost.
As the most common form of credit derivative in a one trillion dollar credit derivatives market, total return swaps are frequently characterized by regulatory authorities as contracts between beneficiaries and guarantors. They are a form of off balance sheet financial instrument that allows one party who can be termed a beneficiary to transfer the exposure of a reference asset to another party called the guarantor. The beneficiary continues to hold the assets. At the end of a swap or its maturity, the underlying asset is priced for purposes of determining the final swap obligation. At maturity, if the beneficiary had purchased the underlying reference asset specifically to hedge the exposure to a guarantor, then the underlying asset would likely be sold and the selling price would establish the final exchange between the two parties. The underlying asset might in the ordinary course be sold to the guarantor. The final selling priced will be compared to the most recent notional amount of the reference assets for the swap and a difference paid. The standardization of swap procedures is derived from the International Swaps and Derivatives Association master agreement and, in part, is responsible for growth in the marketplace.
Regulators recognize that an ideal hedging strategy is back-to-back trading. These are essentially perfectly offsetting transactions wherein a return is received and a return is paid out. Regulators recognize the unique low risk of the situation where an investor owns the reference assets for the swap because in order for the investor to lose money on the trade, both the counterparty would have to default and the underlying asset would have to drop in value below available margin. The joint probabilities of these events occurring in most cases is extremely low. This is comparable to a repo transaction wherein the counterparty buys an asset and relies upon the seller to repurchase the asset within a certain period. In that same situation, in order for the buyer to lose, both the asset and the counterparty would have to decline in value and default respectively.